The Basics of Forex Options

Options are not only used in the stock market, but they are also used in the Forex market. Options allow traders and investors in the currency market to place orders at their own set risk levels.

There are two types of options that are both available to retail traders and investors in the FX market: the traditional call/put option and single payment option trading (SPOT).

The traditional call/put option works very similarly to the stock option. This option allows traders and investors the right to buy from the option seller, at a specific time and price, though they are not obliged to.

Because of the “over-the-counter” nature of Forex option trading, traders and investors in the Forex market can choose specific dates and times of their preferred options with ease. Quotes are issued to them in regarding the premiums that they are required to pay, in order to get the options that they want.

There are actually two types of traditional options available: the American-style option and the European-style option. The American-style option can be used at any point until the date of expiration. However, the European-style option can only be used at the point of expiration.

The main advantage of using the traditional call/put option is that it requires lower premiums than its counterpart. This option also allows traders and investors to be more flexible, since the American-style option allows them to trade and invest even before the expiration date of their options. However, when comparing the traditional call/put option with SPOT, one disadvantage is that it requires extra work to set and execute traditional options.

Single payment option trading bears a similar concept to the traditional call/put option, though there is one main difference: with SPOT, traders and investors give a scenario, get a premium and then receive cash if the given scenario occurs. In other words, SPOT converts options to cash immediately, after the option placed is successful. However if your scenario does not occur, you will be held responsible for the loss of your premium. One advantage of single payment option trading, is that it is very simple and easy. SPOT only requires you to wait for your results after giving your scenario. Another advantage of SPOT, is that it presents a wide variety of choices to traders and investors and they can give their own exact scenarios. However, one disadvantage is that the SPOT premium is higher, costing significantly more when compared to its counterpart.

SPOT has a number of benefits and downsides. Starting with the benefits, single payment option trading limits the financial risks to the premium (the amount of cash paid to purchase the option). SPOT allows for an infinite profit potential. The trader or investor can set their own dates and prices for their preferred options and SPOT initially requires less money. The option not only can limit risks but it can also hedge against cash positions. These options also present to traders and investors the opportunity to trade and invest on future market movement predictions, but without the risk of losing significant amounts of capital. Single payment option trading can also provide us with many choices, including: standard options, one-touch SPOT, no-touch SPOT, double one-touch SPOT, double no-touch SPOT and digital SPOT.

Single payment option trading does have some downsides though. With SPOT, the premiums can vary, depending on the dates and strike prices of options. This also leads to fluctuations in the risk/reward ratio. Traders and investors are also not allowed to trade these options, meaning that you once you buy a SPOT option, you will not be able to sell it. Finally, it can be difficult to predict future market movements, as with SPOT options you will have to be right about both the date and price you give.

The premium price can vary, as previously mentioned. There are multiple factors that can cause the price of the premium to vary, which is why the risk/reward ratio of Forex options trading can also vary. Some factors that determine the price include: intrinsic value, time value, interest rate differential and volatility.

Intrinsic value is the current price, if it was used, of the option. Against the strike price, the position of this price can be described in three different ways: “in the money” when the strike price is higher than the current price, “out of money” when the strike price is lower than the current price and “at the money” when the strike price is at the same level as the current price. Time value reflects the uncertainty of movements in the market in a chosen time period. Generally, the longer the option’s time period, the higher the price of the option will be. Interest rate differential is typically included in the premium, as part of the time value. Changes in interest rates have an impact on the relationship between the strike price and current price. Volatility is also typically included in the premium, as part of the time value. High volatility increases the likelihood that the market price will meet the strike price in a certain time frame. In general, the more volatile currencies require higher premiums.

In conclusion, options present to traders and investors in the Forex market, the opportunity to make a profit with less risk. There are main types of Forex options: the traditional call/put option and single payment option trading (SPOT). Both types bear their own advantages, disadvantages, benefits and downsides. Forex options prevail particularly during periods of high volatility, important economic developments and political uncertainty. It is up to the trader or investor whether or not they take advantage of Forex options.